After a decade of underperformance, Elliott Management is applying pressure to AT&T (T) to make operational changes and to focus on capital returns to shareholders. The activist further highlights my previous investment thesis that the stock has struggled due to empire building and in the process creating a business that is too hard to manage. The $60 price target is unrealistic with the current management team in place leaving a move to the low $40s as the more likely outcome.
Image Source: Activating AT&T website
The Elliott management plan is for AT&T to essentially focus on improving operations via cutting overlapping costs and selling off non-core assets. The activist uses the Verizon Communications (VZ) example of becoming more focused over the last decade, where as AT&T took the wrong path of diversification. The end result is that Verizon has far outperformed AT&T in the last decade while both have underperformed the benchmark S&P 500 index.
Since 2010, Verizon has gone from a 60% focus on wireless to 71%. The company has even dabbled with content creation and online advertising during the period. Those moves likely contributed to even Verizon underperforming the market by about a percentage point a year in this last decade.
In comparison, AT&T has shifted from a 47% wireless business to 38% wireless while the company didn’t move to exit the wireline business. The company now has 40% of the business in categories such as video, content and Latin America that weren’t present in 2010.
Elliott Management sees AT&T having the potential of reaching $60 from following the below strategic plans. For the most part, the plan is to shift focus from large acquisitions to improving operations. The company would utilize all of the free cash flow after the dividend (around $14 billion now) to equally pay down debt and repurchase shares.
Source: Elliott Management letter
For the stock to reach $60, Elliott wants to see the EPS surge to $4.60 by 2022, up from current $3.60 estimates. Once the market slaps a 12 P/E on the stock, investors would get a stock price of $55 while collecting $5 in dividends during the period for the total return of $60 or over 50% in total return by 2021.
Capital Allocation Matters
My investment thesis has long held that the stock would rise if AT&T got out of the empire building business and into focusing on operational improvement and a formal capital allocation plan. In essence, the executive management team needs to shift away from acquisitions and move toward operational execution.
Elliott Management advises the company form a strategic capital allocation framework to convince the market that management won’t go on another acquisition spree. The formal plan is as follows:
- No material M&A
- Annual dividend hikes at ~2%
- Capital allocation with a 50/50 mix of debt repayment and stock repurchases
The key goal here is the company setting a plan of reaching a 2022 leverage ratio below 2.0x. Based on the current EBITDA of $60 billion, the debt target would be $120 billion. If the company can grow EBITDA as proposed by Elliott Management, the debt reduction wouldn’t need to be as much as $30 billion in the next three years with the current corporate goal of reaching $150 billion goal by the end of 2019.
Elliott Management sees the EBITDA margin growing 300 bps only requiring debt reduction to $130 billion by 2022 to reach the leverage ratio. The letter suggests debt repayment of $26 billion starting in 2020, which should actually push the net debt load to $124 billion.
My view is that the large debt balance doesn’t allow the wireless giant to compete with the large tech giants increasingly encroaching on their business so the focus should be towards larger debt repayments. Maybe the company should have a goal of repurchasing shares below $40 with up to 50% of the free cash flow to ensure the cash is used for when clear value exists.
A Yield Too High
To reach $60, AT&T would see the dividend yield dip to 3.4%. Even the proposed 2% annual dividend hikes would place the annual dividend payout at $2.17 in 2022 with the dividend yield at 3.6%.
Even the better operating Verizon has a history of the yield maxing out at 4.0%. The maximum price for a 4.0% yield is about $54 or where Elliott Management expects the stock to reach by 2022. It isn’t clear, if the market would continue buying AT&T below a yield in the mid 4% range
Now, the yield definitely doesn’t have to bottom at 4.0%, but the recent history suggests that yield hungry investors lose interest at levels in the low 4.0% range. AT&T would need to change the growth profile to make the stock more appealing and Elliott Management isn’t proposing a plan that increases revenue growth.
The key investor takeaway is that Elliott Management has a reasonable plan to improve the results and hence the stock returns of AT&T, but the plan requires management to change their stripes. The company has already been reticent to commit to any debt reduction goals beyond this year despite the clear connection with the recent stock gains and debt reduction.
Until executive management changes, the stock isn’t likely going to rally much beyond $40. The decision to hire Goldman Sachs (GS) to defend AT&T from Elliott Management is a step in the wrong direction.
Disclosure: I am/we are long T. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.